Economists
disagree over whether capitalism will result
in full employment

Some say yes, and if there is
unemployment it is usually caused by
government interference

Some say no, and at times
government involvement is needed to move
the economy towards full
employment

From the Instructor's
Manual

(I have highlighed some of the
more important concepts.)

Chapter
Four

The Market
SYSTEM

CHAPTER OVERVIEW

This chapter begins with a discussion of the institutional
framework of the American market system. Brief explanations are given
for these characteristics of the market system: private property,
freedom of enterprise and choice, the role of self-interest,
competition, markets and prices, the reliance on technology and
capital goods, specialization, use of money, and the active, but
limited role of government. In the final section of the chapter, the
authors address the Four Fundamental Questions faced by every economy
and explain how a market economy answers each one.

INSTRUCTIONAL
OBJECTIVES

After completing this chapter, students should be able to:

List and explain nine important characteristics of the
American market system. (NOTES FROM YOUR INSTRUCTOR: or the
6 characteristics highlighted below.)

State the Four Fundamental Questions faced by any economic
system.

Describe how the market system answers each of these four
fundamental questions.

Define normal profits and economic profits and explain the
difference between them.

Identify the relationship between profits and expanding
industries; losses and declining industries.

Explain how the consumer influences the "What goods and
services will be produced?" question.

Explain how a market system achieves economic efficiency.

Explain the role of income distribution on the "Who will
get the goods and services?" question.

Describe the guiding function of prices.

Describe how the market system promotes technological
improvements and capital accumulation.

Explain the role of competition and "invisible hand" in
promoting economic efficiency.

Define and identify terms and concepts at the end of the
chapter.

COMMENTS AND TEACHING
SUGGESTIONS

A surprising number of students do not really understand
the characteristics of the American market system. Many students
have no idea how prices are set and even after the chapter on
supply and demand may still believe that most prices are
determined by an external government agency or by producers
arbitrarily.

If you havent already talked about Adam Smith and his
role in economics, this may be a good time to introduce the
"father of economics." His emphasis on the role of self-interest
in motivating economic activity is especially relevant here. You
might place copies of the "Wealth of Nations" on reserve at the
library to encourage students to sample the original work. You
could use short excerpts as the basis for discussion or essays.
"Adam Smith and the Wealth of Nations," a 28-minute video/film, is
an excellent supplement. Check with your Federal Reserve District
Banks public information office or your nearest Center for
Economic Education for availability.

Markets coordinate economic activity and changes in prices
(products and resources) signal that changes have occurred within
particular markets. A simple example of product X and product Y
can be used. Assume an increase in the demand for X. This change
will lead to an increase in the price of X, an increase in the
profitability of X, an increase in the quantity supplied of X, an
increase in the demand for the resources used to produce X, and an
increase in the prices of the those resources. Because of a limit
in consumer income, the demand for Y is assumed to decrease
followed by all of the changes that will occur in response to the
decrease in the demand of Y. After all of these changes have
occurred, explain how the transferable resources will move from Y
to X. This illustrates the concepts of the "invisible hand" and
allocative efficiency.

(NOTES FROM YOUR INSTRUCTOR: Recall that a problem with a command
economy is the coordination problem from the Bonus web
Chapter.)

This is a good time to reintroduce the concept of goods for
the future from chapter 2. In discussing the importance of
producing goods for the future for the market system, remind the
students of the impact upon the production of consumption goods in
the present.

The four fundamental questions must be answered by all types
of economic systems. Although the emphasis of this chapter is on
the American market system, current economic changes in Russia and
China and areas of the developing world can be discussed to
illustrate how different types of economics answer these questions
differently.

When discussing the first two of the fundamental questions,
ask who in the market economy are most responsible for answering
each of the questions. Explain that the "Who will get the goods
and services?" question is an income distribution question and is
determined by the distribution and productivity of the resources
and the demand for the resources. Discuss how differing demand and
supply conditions in the market for fast food workers and computer
system workers determine the differences in the workers
wages and incomes.

LECTURE NOTES

I. Characteristics of the Market System

A. Private individuals and firms own most of the
private property (land and capital).

1. Private property, coupled with the freedom to
negotiate binding legal contracts, enables individuals and
businesses to obtain, control, use, and dispose of this
property.

1. Freedom of enterprise means that entrepreneurs
and businesses have the freedom to obtain and use resources, to
produce products of their choice, and to sell these products in
the markets of their choice.

2. Freedom of choice means:

a. Owners of property and money resources can
use resources as they choose.

b. Workers can choose the training, occupations, and
job of their choice.

c. Consumers are free to spend their income in such a
way as to best satisfy their wants (consumer
sovereignty).

C. Self-interest

1. Self interest is one of the driving forces in a
market system. Entrepreneurs try to maximize profits or
minimize losses; resource suppliers try to maximize income;
consumers maximize satisfaction.

2. As each tries to maximize profits, income,
satisfaction, the economy will benefit if competition is
present.

(NOTES FROM YOUR INSTRUCTOR: This "self-interest" is very
important. Although some people call it "greed", it is the
driving force behind capitalism and fundamental in capitalism's
success in achieving productive efficiency, allocative
efficiency, and economic growth. "Greedy" business owners will
produce at a minimum cost (achieve productive efficiciency) to
increase their profits. Also, they will use the limited
resources to produce what consumers want (achieve allocative
efficiency) to also increase their profits.)

D. Competition among buyers and sellers is a controlling
mechanism.

1. Large numbers of sellers mean that no single
producer or seller can control the price or market supply.

2. Large number of buyers means that no single consumer
or employer can control the price or market demand.

(NOTES FROM YOUR INSTRUCTOR: Without competition market
economies may not achieve efficiency. This is a major concept
studied in microeconomics and the reason why the promotion of
competition is a policy of Structural Adjustment Programs in
the Transition Economics.)

E. Markets and prices

1. A market system conveys the decisions of the
many buyers and sellers of the product and resource
markets.

2. A change in the market price signals that a change in
the market has occurred.

3. Those who respond to the market signals will be
rewarded with profits and income.

NOTES FROM YOUR INSTRUCTOR: This is why we will study
chapter 3. We have already discussed the importance of prices
in achieving allocative and productive efficiency.

Prices are very important in a market economy. The
"right" product price is necessary to achieve allocative
efficiency and the "right" resource price is necessary to
achieve productive efficiency.

TO DECIDES HOW TO USE ITS LIMITED RESOURCES
TO SATISFY HUMAN WANTS PURE CAPITALISM RELIES
ON:

c. Detroit autoworker produces crankshafts for Buicks. If
the worker were paid in crankshafts, he would have to find
grocers, clothing retailers, etc., who would be willing to
exchange their products for a crankshaft. It is much more
efficient to use money wages than to accept ones wages
in crankshafts!

I. Active, but limited government

1. Although the market system promotes efficiency,
it has certain shortcomings (over production of goods with
social costs, under production of goods with social benefits,
tendency for business to increase monopoly power, macro
instability).

2. Chapter 5 deals with how the government can increase
the overall effectiveness of the market system.

III. The Market System at Work

A. The market system is made up of millions of individual
decision makers who make trillions of decisions all of which are
attempting to maximize their individual or business
self-interest.

B. The market is a mechanism by which the consumers and
producers can come together to respond to each others
desires and wants in an efficient way.

C. Although the focus of this chapter is on the market
system, the four fundamental questions must be answered by all
economic systems.

1. What goods and services will to be produced?

2. How will these goods and services be produced?

3. Who will get the goods and services?

4. How will the system accommodate change?

D. What will be produced?

1. In order to be profitable, businesses must
respond to consumers (individuals, other businesses, and
the government) wants and desires.

2. When businesses allocate resources in a way that is
responsive, businesses will be profitable and
allocative efficiency will
be achieved.

3. Accounting profits are total revenue minus total
accounting costs.

4. In economics, the return to the entrepreneur is treated
just like the return to the worker, i.e., it is an economic
cost and must be received if the entrepreneur is going to
continue to produce in that industry.

5. Normal profits are the return to the entrepreneur that is
necessary for him/her to continue to produce that product. Any
revenue received beyond normal profits is pure or economic
profit.

6. If producers in an industry are receiving pure or
economic profits, additional producers will move into the
industry, the industry supply will increase, and the price will
decrease thus squeezing out the economic profits. Refer to
Figure 3-6(c).

7. If producers in an industry are experiencing economic
losses, some of these producers will exit the industry, the
industry supply will decrease, and the price will increase thus
eliminating the economic losses. Refer to 3-6(d).

8. Consumer sovereignty is the key to determining the
types and quantities of the various products that will be
produced. "Dollar votes" for a product when purchases are made
and "dollar votes" against a product when products are ignored
will determine which industries continue to exist and which
individual products survive or fail.

9. Businesses are not really "free" to produce what they
wish. They must match their production choices with consumer
choices or face losses and eventual bankruptcy. Profit-seeking
firms must consider the allocation of the "dollar votes" when
they make their production decisions.

10. Resource demand is a "derived" demand, i.e., it depends
on the demand for the products produced by the resource.

E. How will the goods and services be produced?

1. The market system encourages and rewards those
producers who are achieving productive
efficiency, i.e., least-cost production.

3. The most efficient technique will be the one that
produces a given amount of output with the smallest input of
scarce resources when both inputs and outputs are measured in
dollars and cents. (Key Question 7)

F. Who will get the goods and services?

1. The answer to this question is directly related
to how the income is distributed among the individuals and the
households and the tastes and preferences of consumers.

2. Products go to those who are willing and able to pay
for them.

3. The productivity of the resources, the relative supply of
particular resources, and the ownership of the resources will
determine the income of individuals and households.

4. The resource markets, which determine income, are linked
to this decision.

G. How will the system accommodate change?

1. Accommodating changes in consumer tastes and the
guiding function of prices:

a. An increase in demand for some products will
lead to higher prices in those markets.

b. A decrease in demand for other products will lead
to lower prices in those markets.

c. Increased demand leads to higher prices that induce
greater quantities of output. The opposite is true for a
decrease in demand.

d. Higher prices lead to more profits and new firms
entering the market.

a. An entrepreneur or firm that introduces a
popular new product will be rewarded with

increased revenue and profits.

b. New technologies that reduce production costs, and
thus product price, will spread

throughout the industry as a result of
competition.

c. Creative destruction occurs when new products and
production methods destroy the market positions of firms
that are not able or willing to adjust.

III. Competition and the "Invisible Hand":

A. Competition is the mechanism of control for the
market system. It not only guarantees that industry responds to
consumer wants, but it also forces firms to adopt the most
efficient production techniques.

B. Adam Smith talked of the "invisible hand" which promotes
public interest through a market system where the primary
motivation is self-interest. By attempting to maximize profits,
firms will also be producing the goods and services most wanted by
society.

IV. LAST WORD: Shuffling the Deck

A. If one thoroughly shuffles a deck of cards, there is a
virtual 100% chance that the resulting arrangement of cards will
be unlike any previous arrangement.

B. Yet, even though there are tens of billions of resources in
the world, these resources are arranged in such a way as to
produce the products and services that serve human needs.

C. Private property eliminates the possibility that resource
arrangements will be random because each resource owner will
choose a particular course of action if it promises rewards to the
owner that exceed the rewards promised by all other available
actions.

D. The result is a complex and productive arrangement of
countless resources.

SUMMARY:

Capitalism provides the incentives (profit) for a
PRODUCTIVELY EFFICIENT use of resources

The price mechanism provides for and ALLOCATIVELY EFFICIENT
use of resources

Capitalism does not have a mechanism to assure EQUITY. This
may be a role of government

Economists disagree over whether capitalism will guarantee
FULL EMPLOYMENT.(We will study this disagreement later.)

The move toward capitalism has resulted in high rates of
ECONOMIC GROWTH in many countries. Profits, private property, and
freedom of enterprise and choice promote growth